Marginal Costing

Marginal Costing

Marginal cost is the variable cost of one unit of product or service. 

Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only variable costs are charged as a cost of sale and a contribution is calculated (sales revenue minus variable cost of sales). Closing inventories of work in progress or finished goods are valued at marginal (variable) production cost. Fixed costs are treated as a period cost, and are charged in full to the profit and loss account of the accounting period in which they are incurred.

The marginal production cost per unit of an item usually consists of the following. 

•Direct materials 

•Direct labour 

•Variable production overheads 

Direct labour costs might be excluded from marginal costs when the work force is a given number of employees on a fixed wage or salary. Even so, it is not uncommon for direct labour to be treated as a variable cost, even when employees are paid a basic wage for a fixed working week. If in doubt, you should treat direct labour as a variable cost unless given clear indications to the contrary. Direct labour is often a step cost, with sufficiently short steps to make labour costs act in a variable fashion. 

The marginal cost of sales usually consists of the marginal cost of production adjusted for inventory movements plus the variable selling costs, which would include items such as sales commission, and possibly some variable distribution costs.

Contribution is an important measure in marginal costing,and it is calculated as the difference between sales value and marginal or variable cost of sales.

Contribution is of fundamental importance in marginal costing, and the term 'contribution' is really short for 'contribution towards covering fixed overheads and making a profit'.

The principles of marginal costing

The principles of marginal costing are as follows. 

a)  Period fixed costs are the same, for any volume of sales and production (provided that the level of activity is within the 'relevant range'). Therefore, by selling an extra item of product or service the following will happen. 

    • Revenue will increase by the sales value of the item sold. 

    • Costs will increase by the variable cost per unit. 

  • Profit will increase by the amount of contribution earned from the extra item. 

b)  Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item. 

c)  Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs. Absorption costing is therefore misleading, and it is more appropriate to deduct fixed costs from total contribution for the period to derive a profit figure. 

d)  When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased. It is therefore argued that the valuation of closing inventories should be at variable production cost (direct materials, direct labour, direct expenses (if any) and variable production overhead) because these are the only costs properly attributable to the product.